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Keep splits simple

The thought of integrating complex financial engineering in an Isa may turn off some advisers, particularly in the midst of a hectic Isa season when keeping it simple is likely to be the IFAs&#39 mantra.

But despite the pitfalls of technical complexity, there are considerable benefits to investors by using split-capital investment trusts, ways of adding value to Isas and keeping it simple.

First, in the conventional sense, any trust that is “dated” offers the planner scope for more accurate prediction of the return. Second, different classes offer different risk profits. Such features are ideal attributes when it comes to using split-capital trusts for Isas.

But, for many, the problems arise in finding the perfect trust for them. The start- ing point for investors is, as always, your objectives – do you want growth or income? What is your attitude to risk, both generally and within the specific context of your Isa?

For the out and out income-seeker, some split-capital investment trust income shares offer yields sufficient to meet the needs of the most demanding of financial planning problems, such as financing nursing home fees.

However, the highest yields are found in shares that are sub-classified as “annuity income shares”, which leave investors with little or no capital at the end of the trust&#39s life.

To increase the tax efficiency, you might rationally think that such shares should be held in Isas. But this is not the type of investment that most would want within an Isa as, while providing shelter from income tax, it does not provide any means of crystallising losses.

At present, most of the annuity income shares on offer are short-dated, with five of the eight in issue coming to the end of their lives in a little less than two years.

Given the current trend of new split-capital investment trusts issuing relatively lower-yielding shares, investors will have to wait and see what type of income products the roll-over vehicles of the short-dated trusts will offer to those seeking ultra-high yields – particularly at a time of low annuity rates and a flattening yield curve which presently suggests interest rates may fall in the short-term.

Investors seeking to maximise both income and capital gains are therefore better directed to review the income and residual capital shares offered by splits.

These shares are sometimes innocuously named ordinary income shares although there is little that is ordinary about them.

They derive their high yields from a split-capital structure in which other share classes forego the right to receive any income, in return for either capital growth or a prior call on assets. Hence, ordinary income shares are extraordinary in that they are geared by the demands of zero dividend preference shares and/or bank debt. Their exceptional level of income is sometimes produced from a combination of structural gearing and a high-yielding underlying portfolio.

For investors who seek more predictable returns, there are many income shares issued by split-capital trusts which have a fixed repayment value, albeit the fixed price of many of these are subject to the trust&#39s underlying performance.

Sadly, for the cautious income-seeker, there are fewer of this type being issued and the attraction of existing shares is such that they tend to be in very tight hands.

Nonetheless, there are some high-income-producing shares that also shelter investors from much of the risk of the market simply through their structures.

The present situation in income shares offers a great deal. Income yields on income and residual capital shares average 9.4 per cent and, assuming asset and dividend growth of 5 per cent, net redemption yields average 13 per cent.

The 24 income shares with fixed repayment values (which include five of the annuity type) offer an average income yield of 19.8 per cent,and a net redemption yield of 15.8 per cent, again assuming 5 per cent a year growth in income, according to Association of Investment Trust Companies&#39 statistics.

The basic information required to make a value judgement is supplied by the AITC in its monthly information service (0207 4315222).

However, the service only provides a means of analysis at a relatively superficial level. It looks at redemption yields on split-capital shares, given various asset or income growth rates over the remaining life of the trust.

But comparing prospective performance using similar assumptions and underlying asset growth is not the end of the story. One must question whether those assumptions are reasonable and is one comparing like with like? For example are the underlying assets comparable? How does the investment objective affect the asset mix and are the assets taxed in the same way?

The trend in investment trusts is to use dual listings in both London and the Channel Islands so to benefit from unfranked income. This enables UK taxpayers who invest in such trusts held in Isas and Peps to benefit from an enhanced income compared with trusts whose dividend is in the form of franked income.

Another development, which has served to improve the long-term prospects of income-seeking investors, is for managers to launch “soft-dated” trusts.

At first, the absence of a fixed life may appear to be self-defeating but there are benefits. For the investor in zeros, the date of crystallisation needs to be fixed. However, holders of the incomeproducing shares need not worry about the reinvestment implications at wind-up.

For example, if interest rates are lower at the wind-up than at launch, the income yield on their investment may not be replicated without extra risk because, in structuring a rollover company,the yield cannot be maintained without increasing the gearing through limiting the number of incomeproducing shares in issue.

Therefore, undated incomeproducing shares are in greater demand and they command a premium over dated stocks in the market.

For growth-seeking investors, Isa tax breaks are modest by comparison with the CGT annual exemption. However, their simplicity, combined with the low-risk nature of zero dividend preference shares, can provide investors with a reliable way of building up a pot growing free both of CGT and any detailed CGT planning.

Zeros currently display more safety features than a Volvo, with the sector boasting asset cover of 160 per cent. A good measure of the cushioning power of this stockmarket shock absorber is the hurdle rate which shows that the underlying assets (90 per cent of which are in the UK market) could dwindle away by 17 per cent a year over the next three and three-quarter years and investors could still see a return of 7.5 per cent a year.

Even though these statistics are skewed by the presence of several well-covered short-dated zeros, they are ideally placed to handle a bear market.

The developments within the sector provide yet further choice – or added confusion – for investors. You have to be sure of the precise nature of each stock. The flurry of new issues which has led to the sector&#39s growth supports the notion that using a managed approach to each class is a safer route than falling foul of the subtleties.

Perhaps the best way for Isa investors to reap the rewards and benefit from the value in the sector is to use the Isas offered by investment trust specialists such as Aberdeen, Exeter and Investec which package them with the IFAs&#39 mantra of simpli-city in mind.


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